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The RBI has continued to focus on inflation as its dominant concern while formulating its monetary policy - evidenced by the decision to keep the repo rate unchanged whilst lowering projected GDP growth. The move also underscores the current dichotomy in the growth/inflation dynamics facing the government and the RBI.

Whilst the tone of the RBI in the macroeconomic review and today's policy document indicates some level of frustration in its inability to cut the repo rate despite the growth slowdown, they have significantly eased liquidity conditions since November 2011 as a counterbalance to the lack of rate cuts. We have seen a significant drop in short term interest rates since March due to benign liquidity conditions.

Expectations were high for a repo rate cut this time around, and the decision to keep rates on hold was not straightforward given the overt pressures from the finance ministry. The RBI has acknowledged government efforts towards fiscal consolidation and pointed out that it would increase headroom for monetary policy action going forward. Rate cuts now appear more likely in the January-March quarter policy meeting as headline inflation readings may in the next two to three months increase from current levels.

The absence of a rate cut in today's policy meeting will affect government bond yields. The postponement in the rate easing cycle may take bond yields higher from current levels as November is a heavy supply month. However, the RBI may look to add further liquidity in the form of OMOs, which even at the lower end of market expectations (up to INR500bn) would potentially account for the entire likely increase in the borrowing programme on any fiscal slippage. If the OMOs are followed up with rate cuts, then we could see a significant fall in long bond yields from current levels.